LBO Definition
An LBO is specific takeover mechanism that consists in financing the acquisition of a company through debt in order to exploit a leverage effect. A holding company is set up to carry the long-term debt. LBOs are typically conducted as follows:
1. Initial stages
Identification of investment funds with the capability of engineering the takeover, and initial meetings with them.
Construction of an in-house team with all the required competencies to develop a five-year plan covering finance, sales, marketing, supply chain, production facilities, and human resources.
Meeting between management team and selected investment fund. The proposal must be robust and well-argued: in an average year, a private equity fund involved in transactions on unlisted companies receives 200 proposals but closes only ten deals.
2. After the fund has been selected
Construction of business plan through an iterative consultation procedure.
Refinement and computation of acquisition- price parameters such as multiple of Earnings Before Interest and Taxes (EBIT), internal rate of return (IRR), etc.
Definition of target valuation range.
3. Post-valuation
Financial engineering and search for the right equity-debt mix on basis of valuation range and cash-flow and EBIT forecasts.
Search for lead bank to manage debt syndication.
Debt packaging and structuring into senior debt and mezzanine debt. (Senior debt is the bank debt raised to finance an acquisition through a leverage effect. The senior banker has guarantees on the assets of the takeover holding company. Mezzanine debt is hybrid financing between senior debt and equity. It is repaid after senior debt, but usually offers a higher return.)
Negotiation of lending rates with banks.
4. Negotiation with seller
Negotiation, usually via a bank.
Agreements on acquisition price and financial arrangements (valuation of goodwill, fixed assets, brand name, etc.).
Definition of a timetable and performance of acquisition audits (financial, environmental, workforce). The purchaser's auditors can examine all relevant documents in a special locale called the data room.
Signing of deal at the “closing” meeting; if need be, definition of a period in which seller will receive support.
An example of an LBO takeover
While the specific arrangements of a takeover cannot be replicated exactly elsewhere, they do give a good illustration of how LBOs work. An LBO takeover comprises four major stages: (1) finding an investment fund with the capability of engineering the takeover; (2) development of a five-year business plan; (3) leverage calculation and financial engineering; (4) negotiation with seller and closing of deal.
Stage 1: Finding an investment fund
The first stage in an LBO is to identify the investment funds capable of taking part in such a deal and to select the fund that will see the deal through to the close. Investment funds are ranked by the size of the transactions in which they participate: $1.5 million, $15 million, $150 million and up, etc. A private equity fund, which handles transactions involving unlisted companies, receives some 200 proposals a year but closes only about ten deals. One also needs to define the structure of the management team that will run the company after the takeover. The team must include all the competencies required to develop a five-year business plan: finance, sales, marketing, production, logistics, and human resources.
Stage 2: Developing the business plan
After the fund has been chosen, the second stage consists in developing the business plan. This is an iterative process. In our case, we can draft nearly a hundred versions to satisfy the acquisition criteria. Three months were needed to reach an agreement, in July, on the management team's commitments to investors over the five following years. We then refine the acquisition-price parameters using fairly complex tools: multiples of EBIT (earnings before interest and taxes), IRR (internal rate of return), etc. Tangible and intangible assets—plants, brands, goodwill,and so on—were valued. We obtain a valuation range for the target.
Stage 3: Determining leverage and engineering the financial package
The most delicate part of the transaction is to determine the debt leverage. The principle of an LBO consists in investing the least possible capital in the acquisition price and borrowing as much as possible. A balance between debt and equity must be struck, taking into account the valuation range and the cash-flow and EBIT forecasts. Once the debt is repaid, the modest capital acquired will be multiplied when investors pull out a few
years later. The financial package includes a structuring of the debt into senior debt and mezzanine debt. Senior debt is the bank debt raised to finance an acquisition through a leverage effect. Its maturity ranges from three to seven years. The senior banker has guarantees on the assets of the takeover holding company. Mezzanine debt is hybrid
financing between senior debt and equity. It is repaid after senior debt, but usually offers a higher return. The investment fund launches a search for the banks capable of syndicating and raising the loans. This is not an easy task. The return for investors who lend funds in an LBO is minimal, but their risk exposure is high. The banks involved in loan syndications receive 2-4% of the amount lent, for periods of five to seven years, with—in some cases—a high risk that the company will not succeed. True, the bank collateralizes the loan on goodwill or other assets, but its return is modest even as it exposes itself to risks in an area where it has no specialist knowledge. When the lead bank is chosen, the management team must put on a true “balancing act” in order to prove its motivation and demonstrate the robustness of its business plan.
Stage 4: Negotiating with the buyer and closing the deal
Once the debt has been structured, sellers and buyers set a final acquisition price. This is followed by a period of several months in which the purchasers' auditors examine the thousands of pages prepared by the seller to present the enterprise. The auditors can peruse the documents in a special locale called the data room. After the seller and buyer have agreed on an approximate price level— some adjustments are usually made —a “due diligence” period begins, in which individuals and companies commissioned by the buyer perform financial, environmental, sales, and marketing audits to test the robustness of the business plan and the reliability of the business data produced by the seller. When the negotiations are over, the deal can be signed at the “closing” meeting. If need be, a period is defined in which the seller will receive support.
